Finance

with the issue of whether stock and bond markets at

any given time are too
high, too low, or about right.

Most academics today subscribe to the following

modified version of Adam Smiths theory:
l A firms principal goal should be to
_________________________________________,
which
means maximizing the value of its stock.
l Free enterprise is still the best economic
system for the country as a whole.
l However, some constraints are needed
firms should not be allowed to pollute the air and
water, engage in unfair employment practices,
or create monopolies that exploit consumers.
Profits depend on sales; and sales require
that firms develop desirable products and services,
produce them efficiently, and sell them at
competitive prices, all of which benefit society.

FORMS OF BUSINESS ORGANIZATION

(1) ___________________, (2) ______________, (3)
______________, and (4) ______________ (LLCs) and
limited liability partnerships (LLPs).
*A proprietorship is an unincorporated business
owned by one individual.
Going into business as a sole proprietor is easya
person begins business operations.
Proprietorships have three important advantages:
(1) They are easily andinexpensively formed,
(2) they are subject to few government regulations,
and
(3) they are subject to lower income taxes than are
corporations. However, proprietorships also have
three important limitations:
(1) Proprietors have unlimited personal liability for
the businesss debts, so they can lose more than the
amount of money they invested in the company. You
might invest $10,000 to start a business but be
sued for $1 million if, during company time, one of
your employees runs over someone with a car.
(2) The life of the business is limited to the life of
the individual who created it; and to bring in new
equity, investors require a change in the structure of
the business.
(3) Because of the first two points, proprietorships
have difficulty obtaining large sums of capital;
hence, proprietorships are used primarily for small
businesses.

Finance versus Economics and Accounting

Finance as we know it today grew out of economics
and accounting. Economists developed the notion
that an assets value is based on the future cash
flows the asset will provide, and accountants
provided information regarding the likely size of
those cash flows. Finance then grew out of and lies
between economics and accounting, so people who
work in finance need knowledge of those two fields.
Finance within an Organization
The board of directors is the top governing
body, and the chairperson of the
board
is
generally
the
highest-ranking
individual. The CEO comes next, but note that the
chairperson of the board often serves as the CEO as
well. Below the CEO
comes the chief operating officer (COO), who is
often also designated as a firms president. The COO
directs the firms operations, which include
marketing,
manufacturing,
sales,
and
other
operating departments. The CFO, who is generally a
senior vice president and the third ranking
officer, is in charge of accounting.
Sarbanes-Oxley Act
A law passed by Congress that requires the CEO and
CFO to certify that their firms financial statements
are accurate.
Corporate Finance, Capital Markets,
and Investments
three areas: (1) financial
management, (2) capital markets, and (3)
investments.
Financial management, also called corporate
finance, focuses on decisions relating to how much
and what types of assets to acquire, how to raise
the capital needed to buy assets, and how to run
the firm so as to maximize its value.
Capital markets relate to the markets where
interest rates, along with stock and bond prices, are
determined. Also studied here are the financial
institutions that supply capital to businesses.
____________ relate to decisions concerning stocks
and bonds and include a
number of activities: (1) ________________ deals with
finding the proper values of
individual securities (i.e., stocks and bonds). (2)
________________ deals with the best
way to structure portfolios, or baskets, of stocks
and bonds. (3) _____________ deals

*A partnership is a legal arrangement between

two or more people who decide to do business
together. Partnerships are similar to proprietorships
in that they can
be established relatively easily and inexpensively.
Moreover, the firms income is allocated on a pro
rata basis to the partners and is taxed on an
individual basis.
This allows the firm to avoid the corporate
income tax. However, all of the partners are
generally subject to unlimited personal liability
*Corporation is a legal entity created by a state,
and it is separate and distinct from its owners and
managers.
It is this separation that limits stockholders losses
to
the amount they invested in the firmthe
corporation can lose all of its money, but its owners
can lose only the funds that they invested in the
company. Corporations also
have unlimited lives, and it is easier to transfer
shares of stock in a corporation than ones interest
in an unincorporated business.
A limited liability company (LLC) is a relatively
new type of organization that is a hybrid between a
partnership and a corporation.
A limited liability partnership (LLP) is similar to
an LLC; but LLPs are used for professional firms in
the fields of accounting, law, and architecture, while
LLCs are used by other businesses.
Shareholder Wealth
Maximization
The primary goal for managers of publicly owned
companies implies that decisions should be made to
maximize the

long-run value of the firms common stock.

Intrinsic Value
An estimate of a stocks true value based on
accurate risk and return data. The intrinsic value
can be estimated but not measured precisely.
Market Price
The stock value based on perceived but possibly
incorrect information as seen by the marginal
investor.
Marginal Investor
An investor whose views determine the actual stock
price.
Equilibrium
The situation in which the actual market price
equals
the intrinsic value, so investors are indifferent
between buying or selling a stock.
Business Ethics
A companys attitude and conduct toward its
employees, customers, community, and
stockholders.
Corporate Raider
An individual who targets a corporation for takeover
because it is undervalued.
Hostile Takeover
The acquisition of a company over the opposition of
its management.
TYPES OF MARKETS
Spot Markets
The markets in which assets are bought or sold for
on-the-spot delivery.
Futures Markets
The markets in which participants agree today to
buy or sell an asset at some future date.
Money Markets
The financial markets in which funds are borrowed
or loaned for short periods (less than one year).
Capital Markets
The financial markets for stocks and for
intermediate or
long-term debt (one year or longer).
Primary Markets
Markets in which corporations raise capital by
issuing new securities.
Secondary Markets
Markets in which securities and other financial
assets are traded among investors after they have
been
Private Markets
Markets in which transactions are worked out
directly between two parties.
Public Markets
Markets in which standardized contracts are traded
on organized
exchanges.

Derivative
Any financial asset whose value is derived from the
value of some other underlying asset.
FINANCIAL INSTITUTIONS
Investment Bank
An organization that underwrites and distributes
new investment securities and helps businesses
obtain financing.
Commercial Bank
The traditional department store of finance serving
a variety of savers and borrowers.
Financial Services
Corporation
A firm that offers a wide range of financial services,
including investment banking, brokerage operations,
insurance, and commercial banking.
Credit unions
are cooperative associations whose members are
supposed to have a common bond, such as being
employees of the same firm. Memberssavings are
loaned only to other members, generally for auto
purchases, home improvement loans, and home
mortgages. Credit unions are often the cheapest
source of funds available to individual borrowers.
Pension funds are retirement plans funded by
corporations or government agencies for their
workers and administered primarily by the trust
departments of commercial banks or by life
insurance companies. Pension funds invest primarily
in bonds, stocks, mortgages, and real estate.
Life insurance companies take savings in the form
of annual premiums; invest these funds in stocks,
bonds, real estate, and mortgages; and make
payments
to the beneficiaries of the insured parties. In recent
years, life insurance companies have also offered a
variety of tax-deferred savings plans designed to
provide benefits to participants when they retire.
Mutual Funds
Organizations that pool investor funds to purchase
financial instruments and thus reduce risks through
diversification.
Money Market Funds
Mutual funds that invest in short-term, low-risk
securities and allow
investors to write checks against their accounts.
Exchange Traded Funds (ETFs)
are similar to regular mutual funds and are
often operated by mutual fund companies. ETFs buy
a portfolio of stocks of a certain typefor example,
the S&P 500 or media companies or Chinese
companiesand then sell their own shares to the
public.
Hedge funds
are also similar to mutual funds because they
accept money from savers and use the funds to buy
various securities, but there are some important
differences. While mutual funds (and ETFs) are
registered and regulated by the Securities and
Exchange Commission (SEC), hedge funds are
largely unregulated.

Private equity companies

are organizations that operate much like hedge
funds;
but rather than buying some of the stock of a firm,
private equity players buy and then manage entire
firms.
THE STOCK MARKET - where the prices of firms
stocks are established.
Physical Location Exchanges
Formal organizations having tangible physical
locations that conduct auction markets in
designated (listed) securities.
Over-the-Counter (OTC) Market
A large collection of brokers and dealers, connected
electronically by telephones and computers, that
provides for trading in unlisted securities.
Dealer Market
Includes all facilities that are needed to conduct
security transactions not conducted on the physical
location exchanges.
THE MARKET FOR COMMON STOCK
Some companies are so small that their common
stocks are not actively traded; they are owned by
relatively few people, usually the companies
managers. These firms are said to be privately
owned, or closely held, corporations; and their stock
is called closely held stock.
Closely Held Corporation
A corporation that is owned by a few individuals who
are typically associated with the firms
management.
Publicly Owned Corporation
A corporation that is owned by a relatively large
number of individuals who are not actively involved
in the firms management.
Types of Stock Market Transactions
*Outstanding shares of established publicly
owned companies that are traded: the secondary
market.
*Additional shares sold by established publicly
owned companies: the primary market.
*Initial public offerings made by privately held
firms: the IPO market.
Going Public
The act of selling stock to the public at large by a
closely held corporation or its principal stockholders.
Initial Public Offering (IPO) Market
The market for stocks of companies that are in the
process of going public.
STOCK MARKET EFFICIENCY
To begin this section, consider the following
definitions:
Market price: The current price of a stock. For
example, the Internet showed that on one day,
GSKs stock traded at $45.89. The market price had
varied
from $45.42 to $46.23 during that same day as buy
and sell orders came in.
Intrinsic value: The price at which the stock would
sell if all investors had all knowable information
about a stock.
Equilibrium price: The price that balances buy and
sell orders at any given time. When a stock is in

equilibrium, the price remains relatively stable until

new information becomes available and causes the
price to change.
Efficient market: A market in which prices are
close to intrinsic values and stocks seem to be in
equilibrium.
CHAPTER 3
FINANCIAL STATEMENTS AND REPORTS
Annual Report
A report issued annually by a corporation to its
stockholders. It contains basic financial statements
as well as managements
analysis of the firms past operations and future
prospects.
*the report provides these four basic financial
statements:
1. The balance sheet, which shows what assets
the company owns and who has claims on those
assets as of a given datefor example, December
31, 2008.
2. The income statement, which shows the firms
sales and costs (and thus profits) during some past
periodfor example, 2008.
3. The statement of cash flows, which shows
how much cash the firm began the year with, how
much cash it ended up with, and what it did to
increase or decrease its cash.
4. The statement of stockholders equity, which
shows the amount of equity the stockholders had at
the start of the year, the items that increased or
decreased equity, and the equity at the end of the
year.
Balance Sheet
A statement of a firms financial position at a
specific point in time.
Stockholders' equity = Paid -in capital
Retained earnings
Stockholders' equity = Total assets -- Total
liabilities
Several additional points about the balance
sheet should be noted:
Cash versus other assets. Although assets
are reported in dollar terms, only the cash
and equivalents account represents actual
spendable money. Accounts receivable
represents credit sales that have not yet
been collected. Inventories show the cost of
raw materials, work in process, and finished
goods. Net fixed assets represent the cost
of the buildings and equipment used in
operations minus the depreciation that has
been taken on these assets.

Working capital. Current assets are often

called working capital because these assets
turn over; that is, they are used and then
replaced throughout the year

Net working capital. When Allied buys

inventory items on credit, its suppliers, in
effect, lend it the money used to finance the
inventory items.

Other sources of funds. Most companies

(including Allied) finance their assets with a

combination of current liabilities, long-term

debt, and common equity.

Depreciation. Most companies prepare two

sets of financial statementsone is based on
Internal Revenue Service (IRS) rules and is
used to calculate taxes;

Market values versus book values.

Companies generally use GAAP to determine
the values reported on their balance sheets.
In most cases, these accounting numbers (or
book values) are different from what the
assets would sell for if they were put up for
sale (or market values).

The time dimension. The balance sheet is a

snapshot of the firms financial position at a
point in timefor example, on December 31,
2008.

THE INCOME STATEMENT

Income Statement
A report summarizing a firms revenues, expenses,
and profits during a reporting period, generally a
quarter or a year
Operating Income
Earnings from operations before interest and taxes
(i.e., EBIT).
Operating income or EBIT = Sales revenues
-Operating costs
Earnings per share = EPS =
Net income
Common shares outstanding
Dividends per share = DPS = Dividends paid to
common stockholders
Common shares outstanding
Depreciation
The charge to reflect the cost of assets used up in
the production process. Depreciation is not a cash
outlay.
Amortization
A noncash charge similar to depreciation except that
it is used to write off the costs of intangible assets.
EBITDA
Earnings before interest, taxes, depreciation, and
amortization.
Statement of Cash Flows
A report that shows how things that affect the
balance
sheet and income statement affect the firms cash
flows.
a.Operating Activities. This section deals with
items that occur as part of normal ongoing
operations.
b. Net income. The first operating activity is net
income, which is the first source of cash. If all sales
were for cash, if all costs required immediate cash
payments, and if the firm were in a static situation,
net income would equal cash
from operations.
c. Depreciation and amortization. The first
adjustment relates to depreciation and amortization.
Therefore, depreciation must be added back to net
income when net cash flow is determined.

d. Increase in inventories. To make or buy

inventory items, the firm must use cash. It may get
some of this cash as loans from its suppliers and
workers (payables
and accruals); but ultimately, any increase in
inventories requires cash
e. Increase in accounts receivable. If Allied
chooses to sell on credit, when it makes a sale, it
will not immediately get the cash that it would have
received had it
not extended credit. To stay in business, it must
replace the inventory that it sold on credit; but it
wont yet have received cash from the credit sale.
F . Increase in accounts payable. Accounts
payable represent a loan from suppliers.
g. Increase in accrued wages and taxes. The
same logic applies to accruals as to accounts
payable.
h. Net cash provided by operating activities.
All of the previous items are part of normal
operationsthey arise as a result of doing business.
When we sum them, we obtain the net cash flow
from operations.
i. Long-Term Investing Activities. All activities
involving long-term assets are covered in this
section. Allied had only one long-term investment
activity the acquisition of some fixed assets, as
shown on Line j.
j. Additions to property, plant, and equipment.
Allied spent $230 million on fixed assets during the
current year. This is an outflow; therefore, it is
shown in
parentheses.
k. Net cash used in investing activities. Since
Allied had only one investment activity, the total on
this line is the same as that on the previous line.
l. Financing Activities. Allieds financing activities
are shown in this section.
m. Increase in notes payable. Allied borrowed an
additional $50 million from its
bank this year, which was a cash inflow.
n. Increase in bonds (long-term debt). Allied
borrowed an additional $170 million from long-term
investors this year, giving them newly issued bonds
in exchange for cash. This is shown as an inflow.
When the bonds are repaid some years hence, this
will be an outflow.
o. Payment of dividends to stockholders.
Dividends are paid in cash, and the $57.5 million
that Allied paid out is shown as a negative amount.
p. Net cash provided by financing activities.
The sum of the three financing entries, which is a
positive $162.5 million, is shown here. These funds
were used to help pay for the $230 million of new
plant and equipment and to help cover the deficit
resulting from operations.
q. Summary. This section summarizes the change
in cash and cash equivalents over the year.
r. Net decrease in cash. The net sum of the
operating activities, investing activities, and
financing activities is shown here.
s. Cash and equivalents at the beginning of
the year. Allied began the year with the $80 million
of cash, which is shown here.
t. Cash and equivalents at the end of the year.
Allied ended the year with $10 million of cash, the
$80 million it started with minus the $70 million net
decrease as shown previously.
Statement of Stockholders Equity
A statement that shows by how much a firms equity
changed during the year and why this change

Free Cash Flow (FCF)

The amount of cash that could be withdrawn from a
firm without harming its ability to operate and to
produce future cash flows occurred.
INCOME TAXES
Progressive Tax
A tax system where the tax rate is higher on higher
incomes. The personal income tax in the United
States, which ranges from 0% on the lowest
incomes to 35% on the highest incomes, is
progressive.
Marginal Tax Rate
The tax rate applicable to the last unit of a persons
income.
Average Tax Rate
Taxes paid divided by taxable income.
Capital Gain or Loss
The profit (loss) from the sale of a capital asset for
more (less) than its purchase price.
Alternative Minimum
Tax (AMT)
Created by Congress to make it more difficult for
wealthy individuals to avoid paying taxes through
the use of various deductions.
Tax Loss Carry-Back or
Carry-Forward
Ordinary corporate operating losses can be carried
backward for 2 years and carried forward for 20
years to offset taxable income in a given year
S Corporation
A small corporation that, under Subchapter S of the
Internal Revenue Code, elects to be taxed as a
proprietorship or a partnership yet retains limited
liability and other benefits of the corporate form
Chapter 4
RATIO ANALYSIS
1. Liquidity ratios, which give us an idea of the
firms ability to pay off debts that are maturing
within a year.
2. Asset management ratios, which give us an
idea of how efficiently the firm is
using its assets.
3. Debt management ratios, which give us an
idea of how the firm has financed its assets as well
as the firms ability to repay its long-term debt.
4. Profitability ratios, which give us an idea of
how profitably the firm is operating and utilizing its
assets.
5. Market value ratios, which bring in the stock
price and give us an idea of what investors think
about the firm and its future prospects.
LIQUIDITY RATIOS
Liquid Asset
An asset that can be converted to cash quickly
without having to reduce the assets price very
much.
Current Ratio
This ratio is calculated by dividing current assets by
current liabilities. It indicates the extent to which
current liabilities are covered by those assets
expected to be converted to cash in the near
future.

Quick (Acid Test) Ratio

This ratio is calculated by deducting inventories
from current assets and then dividing the remainder
by current liabilities.

Inventories are typically the least liquid of a

firms current assets; and if sales slow down,
they might not be converted to cash as
quickly as expected. Also, inventories are the
assets on which losses are most likely to
occur in the event of liquidation. Therefore,
the quick ratio, which measures the
firms ability to pay off short-term
obligations without relying on the sale
of inventories, is important.
ASSET MANAGEMENT RATIOS
-measure how effectively
the firm is managing its assets.
Inventory Turnover Ratio
This ratio is calculated by dividing sales by
inventories.
*Allieds low inventory turnover ratio also makes us
question the current ratio. With such a low turnover,
the firm may be holding obsolete goods that are not
worth their stated value
Days Sales Outstanding (DSO)
This ratio is calculated by dividing accounts
receivable by average sales per day; it indicates the
average length of time the
firm must wait after making a sale before it receives
cash.
The Fixed Assets Turnover Ratio
the ratio of sales to net fixed assets, measures how
effectively the firm uses its plant and equipment
Total Assets Turnover Ratio, measures the
turnover of all of the firms assets; and it is
calculated by dividing sales by total assets
DEBT MANAGEMENT RATIOS
Total Debt to Total Assets
The ratio of total debt to total assets, generally
called the debt ratio, measures the percentage of
funds provided by creditors. Creditors prefer low
debt ratios because the lower the ratio, the greater
the cushion against creditors losses in the event of
liquidation. Stockholders, on the other hand, may
want more
leverage because it can magnify expected earnings,
Times-Interest-Earned (TIE) Ratio
The ratio of earnings before interest and taxes
(EBIT) to interest charges; a measure of the firms
ability to meet its annual interest payments.
*The TIE ratio measures the extent to which
operating income can decline before the firm is
unable to meet its annual interest costs. Failure to
pay interest will bring legal action by the firms
creditors and probably result in bankruptcy.
PROFITABILITY RATIOS
Operating margin, calculated by dividing
operating income (EBIT) by sales, gives the
operating profit per dollar of sales
Profit Margin
This ratio measures net income per dollar of sales
and is calculated by dividing net income by sales.

Return on Total Assets (ROA)

The ratio of the net income to total assets.

on their money, and this ratio tells how well they are
doing in an accounting sense.

*Allieds 5.9% return is well below the 9.0%

industry average. This is not goodit is obviously
better to have a higher than a lower return on
assets. Note, though, that a low ROA can result from
a conscious decision to use a great deal of debt, in
which case high interest expenses will cause net
income to be relatively low.

DuPont Equation
A formula that shows that the rate of return on
equity can be found as the product of profit margin,
total assets turnover, and the equity multiplier. It
shows the relationships among asset management,
debt management, and profitability ratios.

Basic Earning Power (BEP) Ratio

This ratio indicates the ability of the firms assets to
generate operating income; it is calculated by
dividing EBIT by total assets.
Return on Common Equity (ROE)
The ratio of net income to common equity;
measures
the rate of return on common stockholders
investment. *Stockholders expect to earn a return

Benchmarking
The process of comparing a particular company with
a set of benchmark companies.
Window Dressing
Techniques
Techniques employed by firms to make their
financial
statements look better than they really are